Leverage and mortgage REITs – Part 3

Leverage magnifies rewards. It also magnifies risk. As leverage increases, the margin for error decreases. In other words, if you are unlevered, and you have a security paying 2.71%, the security has to fall 2.71% in price before you start losing money. As leverage increases, that margin decreases. At a 4:1 leverage, it takes a mark-to-market hit of 2.3% before you start losing money. So, as a general rule, the riskier (or more volatile the asset is), the less leverage you would use.

REITs will generally leverage and de-leverage based on their view of interest rate volatility and the direction of interest rates. Since REITs mark-to-market, they have to worry about the price of their assets falling, so if they anticipate rates are about to rise, they will reduce the leverage on their portfolio. Conversely, if they think rates are about to fall, they will increase leverage.

The difference is apparent in the agency versus non-agency space. PennyMac (PMT) invests in distressed mortgage backed securities. These are often bought at a fraction of par – PennyMac will use very little (if any) leverage on these securities. In fact, they may find that their bank will refuse to take them as collateral for a loan. The prices for these securities can be extremely volatile, which makes them unsuitable for much leverage, if any.

An agency REIT, like Annaly (NLY), can use up to 12x leverage. They will probably lever 6x or more. While a mezzanine tranche of a sub-prime deal can go from 80 to 20, a Ginnie Mae security will not. Ginnies are sovereign debt where price movement is determined by interest rate risk, not credit risk. That said, you can still see movement in agency securities. The chart above shows what has happened to the Fannie Mae 3% TBA price since November. It has fallen almost 5%. That is almost two years of interest.